Monthly Archives: December 2016

Navigating the low-return environment has been one of the top concerns for fixed income investors throughout 2016. Consider the fact that 35% of the global treasury market (as of this writing) is trading at negative nominal yields, which begs the question: Why are interest rates so low?

The common assumption is that the Federal Reserve and other central banks are keeping rates low, or that the cause is the 2008 financial crisis. In our view, however, this thinking is not entirely accurate. In fact, low interest rates are not a recent phenomenon. Real 10-year yields in the U.S. have been declining since the 1980s. Nominal 10-year yields were low in the 1960s, peaked at 15% in 1981, and have been falling ever since.

With an interest rate hike at the December 13-14 FOMC meeting seen as a foregone conclusion, we have to ask: What is the upper limit of the Fed’s potential to raise rates, given the long-term trend? How effective is Fed policy likely to be in the future? These are important questions because low long-term rates could very well mean that equities and other “risky” assets will remain overvalued, while fixed income investors struggle to meet target returns.

To address our Fed questions, we start with the understanding that the Fed cannot create growth; it can only affect money supply and nominal rates. The Fed is unable to solve economic changes or even influence real rates. Therefore, tracking the state of the economy is what ultimately determines long-term real returns. At Astor, we track economic trends using our proprietary Astor Economic Index®, and incorporate economic data into our portfolio allocation decisions.

Second, the long-term trend in real rates has rendered Fed policy tools such as the “Taylor Rule” ineffective. (Named for Stanford University economist John Taylor, the Taylor Rule was used previously to predict interest rates based on inflation, GDP, or other economic factors.) The Taylor Rule assumes a constant neutral or equilibrium Fed Funds rate, whereas both the FOMC and the markets agree that the neutral rate is much lower. In March 2015, Fed Chair Janet Yellen admitted to a non-constant neutral rate policy, and others including Fed Vice Chairman Stanley Fischer and former Fed Chair Ben Bernanke also have spoken at length about it.

Third, we also have seen FOMC participants consistently shift down their long-term economic projections. The reasons for these diminished views are the same reasons why interest rates are low; hence these are the variables that we at Astor are watching closely:

Productivity – Growth in productivity has been disappointing, averaging only 0.5% in the last seven years, compared to economists’ forecasts of more than 2%.

Payrolls and Growth — Even though payrolls have showed a lot of improvement—this has not translated into faster economic growth, which, in our view, can only mean that the U.S. growth potential has been lowered as well.

Inflation — Wages have remained stagnant, and inflation hasn’t gone up, despite the growth in payrolls. The only likely explanation, as we see it, is that the relationship between wage and payroll growth has changed because inflation expectations are much lower.

Structural factors – Factors such as a high savings rates, shifting demographics, and low capital spending and investment also have lowered the real interest rate.

Taking all these factors into consideration, our conclusion is that, without improvement, it’s questionable how effective Fed policy can be in the future—and possibly during the next recession, whenever that occurs—because the Fed cannot change the real economy. In addition, after its quantitative easing (QE), the Fed holds more than $4.2 trillion in assets, mainly Treasury bonds and mortgage securities. This raises another question—will the Fed become an active seller moving forward, and how will that further impact fixed income securities?

As we consider what the Fed will do moving forward, these questions will remain on our radar.

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.

The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. The Astor Economic Index® is a tool created and used by Astor. All conclusions are those of Astor and are subject to change.

The latest market surge, as the Dow powers toward 20,000, is being called the “Trump stock market rally.” But as an economist and a realist, I have to question whether stocks would rally this much just on hope and expectations for a new administration, without the help of some other catalyst.

Granted, since the election, moves in the stock market have been significant: the Russell 2000 index of small-cap stocks has gained about 20% and the S&P 500 about 8%. Conversely, bond prices have taken a beating, although no one is calling that the “Trump Bond Dump.”

As I dig deeper into the stock market rally, I believe there is another explanation for the most recent strong upward move in equities. For one thing, we are no longer barraged by the election drama. Uncertainty is gone; we know who won. Minus uncertainty, the market can shake off fear and resume its trend that, prior to the election, had been upward. (Recall that we were at previous all-time highs in the S&P this past summer, propelled higher by an improving employment picture.)

My point here is not to be political. Politics and economics are two very different animals who have to play nice in the jungle. But I do believe that this rally would have occurred no matter who won the election, based on the strength of the current economic fundamentals.

This is not meant to take anything away from President-elect Trump’s plans. Some investors are interpreting the Trump agenda as being supportive of the economy. There are some proposals, however, that could hurt stocks, such as limitations on international trade. In addition, increased spending and lower tax revenue could lead to a larger deficit, while policies that could lead to accelerated interest rate hikes would make it harder for corporations to float debt. And for all his ideas that could stimulate growth (e.g. infrastructure investments) at least in the short run, keep in mind that it takes a lot for anyone to execute a plan into action.

As an aside, it’s interesting to note how names get associated with certain things to describe or define them in some way. Think Watergate of the Nixon era; now any conspiracy or controversy is the next “Something-Gate”—immediately conveying a meaning, and a negative one at that. Health care reform—officially known as the Patient Protection and Affordable Care Act—is nicknamed Obamacare for the president who made it a policy hallmark. Ronald Reagan’s economic policies were dubbed Reaganomics. And the list goes on. Now, as we head to Inauguration Day in January, Trump appears to have his first label whether he deserves full credit for it or not: the Trump stock market rally.

But let’s be clear: This rally, as I see it, is not just built on hopes for what might happen with the new administration. Rather, it reflects what is already happening, namely improvements in economic fundamentals. The Astor Economic Index® (AEI) is showing the economy growing at an above-average rate.

Unemployment continues to drop, with a current rate of 4.6%, the lowest level since mid-2007, while wage growth has also been rising steadily. GDP has improved, particularly in the second half of the year. Inflation, which has been negligible, is moving toward the Federal Reserve’s 2% target. And, the Federal Reserve appears to be giving a vote of confidence to the economy with a widely expected short-term rate hike. Globally, the economic picture appears to be bottoming out after a prolonged period of malaise, and growth is starting to tick up.

No matter what the stock market rally is called or who gets credit for it, I believe it’s important to view it in the context of fundamental realities: U.S. economic growth is accelerating, an environment that we, at Astor, believe to be supportive of buying stocks and other risk assets.

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.

The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. The Astor Economic Index® is a tool created and used by Astor. All conclusions are those of Astor and are subject to change.

As we look back on 2016, a notable theme is just how wrong the markets were when it came to predicting events and risk drivers.

The year began on a pessimistic note. By the February 11 low, the S&P 500 had lost more than 10%, and high-yield bonds were down more than 5%. A major culprit was sharply declining oil prices; WTI crude was down nearly 30%, which drove down commodities as a whole.

Market jitters were also caused by expectations that China’s growth rate was going to fall short, which further compounded concerns about global growth in general.

Now, at year end, the picture looks much different. Global growth in 2016 couldn’t have been better. In the U.S., a third quarter GDP reading of 3.2% exceeded expectations.

Meanwhile, China grew steadily in 2016 at a rate of about 6.7%. As a result, over the first 10 months of 2016, investors have poured more than $50 billion into emerging market stock and bond funds.

As for market performance, year-end is nearly a mirror opposite of what occurred at the start of the year. From January through end-November, the S&P 500 is up about 10%. High-yield bonds are up more than 15% year-to-date, and oil has gained almost 25%.

The second major thing that the markets got wrong was the expectation for rate hikes by the Federal Reserve. When 2016 began, the expectation was that four rate hikes were likely. In January, Fed Vice Chairman Stanley Fischer said that four rate hikes for the year were “in the ballpark,” although China’s slower economy and other uncertainties made it impossible to predict what would happen to interest rates.

The concern in early 2016 was that if the Fed pursued the expected course, the U.S. would go in one direction with interest rates, while the rest of the world was headed lower; in some countries more negative rates were possible.

As we now know, the Fed took a more guarded stance in 2016, following its December 2015 move, which was the first rate hike in almost a decade. This change in expectations affected currencies most of all. The U.S. dollar was expected to rally, but fell 6% in the first half of the year. In contrast, the Japanese yen appreciated through August due to safe haven trades.

Now that we are at the end of the year, we can see how the markets did adjust to changing realities. In fact, both the Fed and the market appear to be aligned. The widespread expectation, already priced into the market, is that the Fed will raise rates at its mid-December FOMC meeting.

The year, though, is not over yet. No matter how clear things may appear, we still think predicting policy events, central bank actions, and the market’s reactions will always be a challenge.

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.

For my last economic update of the year I will review where we are today and try to read the tea-leaves of the incoming Trump administration. The president elect is lucky in inheriting a solidly growing economy. His penchant for decisive action may run into procedural roadblocks in Washington which could significantly delay actions which require congressional approval. Overall I see few significant effects in the coming months.

Our latest reading for the Astor Economic Index® (“AEI”) improved over the month and currently shows the US economy as growing somewhat above average. I also see modest improvement year over year. As this is the last update of 2016 I can say that I am pleased with the performance of our index as an economic gauge over the last 12 months. Memories may be dusty, but a year ago there was widespread concern about US economic weakness. The AEI was showing only minor declines at the time and, in fact, no extended decline in the boarder economy occurred. The AEI is a proprietary index that evaluates selected employment and output trends in an effort to gauge the current pace of US economic growth.

The new president’s first element of luck is an economy running at full employment. Last Friday’s employment report was fairly strong – showing the economy continues to add jobs faster than the number of new entrants to the work force. Levels of both unemployment and underemployment (ie, involuntary part time work) have both dropped significantly in recent months. Recently we have seen a trend of improving wages. That trend weakened slightly this month but the year on year improvement is still significant.

The nowcasts produced by the Federal Reserve banks of Atlanta and New York are both still showing strong growth in the fourth quarter. The Atlanta Fed is currently estimating 2.6% SAAR and the New York Fed is currently forecasting 2.7%. Both somewhat above the average for the current expansion. Both estimates have been updated since the release of the employment number for November.

There is another element of luck in the external environment – what is going on with our trading partners around the world. I attribute the last few years tepid industrial production growth to weak external demand and the strength of the dollar.

The chart below is the GDP weighted average of the individual purchasing managers indexes. I intend it to be proxy for the change in demand in the world manufacturing cycle.

This reading is now approaching its highs from 2014 – suggesting that the weak global manufacturing environment may be improving. Mitigating this global good news somewhat is the performance of the dollar which has set new highs in trade weighted terms. This makes it harder for business to export, though dollar is not seeing the sharp rise it experienced in June 2014- December 2016 period.

The contours of economic policy under the Trump administration have yet to be fully fleshed out. One interpretation of the market action since the election is that there is a substantial likelihood of fiscal stimulus in the form of tax cuts and perhaps infrastructure spending. The President will need to negotiate with both the House and the Senate which have different priorities than does the President Elect. Additionally the GOP holds only slim majorities in both houses, increasing the chance for a small number of legislators to derail the process – at least temporally. If the normal timetable holds we will not see a budget from the new administration until February and House and Senate budgets until March. The negotiation process will then begin. This gives plenty of time for the markets to be disappointed by what may turn out to be an unusually public negotiating style.

The morning after the election I noted that the president has much more autonomy in trade policy. I feel that my comments are still germane: unlike in fiscal policy, the President is able take unilateral actions which may sound like the first shots in a trade war. Combine fiscal policy with trade policy and era of Government By Tweet may offer plenty of examples of what my bond trader father used to call Tape Bombs. These are shocks in the form of unexpected, inherently unpredictable pieces of news which the market reacts and over-reacts too. Recall the summer and fall of the debt ceiling to get a sense of what I mean.

At Astor we think that in times like these is even more important to approach the markets with a discipline which clarifies decision making by keeping the focus on facts not predictions. In our case we will continue to use the state of the of the business cycle as it unfolds as our key input in making investment decisions.

Closing with the fed, my judgement and that of the fed funds futures market (which has a conventional interpretation, see this CME page for example) is that the FOMC will raise rates at the next meeting. The using the same interpretation of the fed fund futures curve shows that the market expecting another hike or two by next year, though the market has been repeatedly disappointed in the last several years. Two things which could make the fed hike more quickly than the market expects would be a sustained rise in core inflation or the prospect of substantial fiscal stimulus. Keep on the lookout for comments by fed governors making the connection between the monetary and fiscal stances of the US.

Overall the economy continues its recent path of modest growth. With some headwinds dissipating we may be hope that next year will be on the upper end of the recent range of growth. As always we will continue to monitor the economy closely.

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.

The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. The Astor Economic Index® is a tool created and used by Astor. All conclusions are those of Astor and are subject to change.

Receive Posts via Email

Enter your email address to follow this blog and receive notifications of new posts by email.

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.